Written by

Dr. Rumki Majumdar

Published

March 21, 2014

India has been facing multiple fundamental domestic challenges, and, with every passing quarter, the focus of issues concerning the economy shifts. Some challenges are more persistent and recur frequently, such as inflation. High inflation has constantly afflicted India for more than half a decade, and, barring a few months, consumer price inflation remained in double digits for the whole of calendar year 2013. At the same time, a few challenges have been sporadic, and some of them completely new, but these have still severely impacted the economy’s health and outlook. Last year, India’s currency experienced a strong depreciation due to a high current account deficit (the level recorded in fiscal year [FY] 2012–13 was the highest ever) and high capital outflows (post the US Federal Reserve’s hint of tapering its monetary policy easing). Political uncertainty and policy challenges aggravated the situation, raising doubts about the economy’s ability to sustain growth. Global economic uncertainty and geopolitical tensions in different parts of the world added to the economic woes. These recurring and periodic challenges weighed upon economic growth, as reflected in the release of the Q3 data of FY 2013–14 GDP and revisions of the GDP numbers for earlier years.

Slower growth

As per the recent release, annual real GDP growth estimates for FY 2012–13 were revised down by five percentage points, to 4.5 percent, due to lower-than-expected growth in primary and secondary sectors (figure 1). Growth in the secondary sector (which constitutes manufacturing, electricity, gas and water supply, and construction) was reduced to half its earlier estimate due to the poor performance in all its subsectors.

The growth estimates for the first two quarters of FY 2013–14 have not been revised yet. However, the third-quarter growth estimates are based on the first revised estimates of 2013–14. The revision indicates poor growth of 4.7 percent year over year. In other words, the downward revision of earlier growth estimates and weaker growth in the latest quarter indicate that the economy is on the path of a sustained slowdown.

Growth in the services industries improved in Q3 of FY 2013–14, but growth in the agriculture, manufacturing, and construction sectors slowed significantly, weighing down overall economic growth. The fall in growth in the manufacturing and the construction sectors was probably a combined effect of low business confidence, poor investment growth, slowing domestic demand, and tightening of monetary policies by the Reserve Bank of India (RBI).

Tighter credit conditions

The RBI raised its key policy rate by 25 basis points to 8 percent for the third time in five months in order to check rising prices and anchor inflation expectation. This raise is in line with the recommendations of an expert committee, set up by the RBI governor, to adopt consumer price inflation as the nominal anchor for monetary policy framework, with a target of 4 percent with a range of 2 percent around it in the long term. After credit conditions were tightened, the inflation rate has come down in the last two months. The consumer price index fell to 7.2 percent year over year in January 2014, to its lowest level in the last two years. Food price inflation, which has contributed the most to overall prices, has also been contracting.

That said, the rise in wages (especially in services) and in prices of intermediaries, as well as structural bottlenecks, has been contributing substantially to the rising prices, and tight credit conditions help to check a price rise. If the desired rate of inflation is 8 percent by January 2015 and 6 percent by the beginning of 2016, as advocated by the expert committee, it is expected that credit conditions will likely remain tight in the near future as well.

The volatility in currency and capital flows has stabilized in recent months.

Outlook for the current quarter

While the underlying economic growth trends are weak, the downside risks to the economy have reduced substantially compared with 2013. India’s trade balance has improved owing to the rise in exports. Inflation is likely to remain contained as the impact of the interest rate hike starts kicking in and domestic demand falls. Commodity prices are also falling due to poor growth and financial uncertainty in China as well as geopolitical tensions in the Middle East and eastern European countries. India is a net importer of oil and oil products; any fall in global prices of oil will be reflected in the movement in domestic prices.

The volatility in currency and capital flows has stabilized in recent months. Investors’ perceived risks about the implications of US monetary policy tapering have been diminishing. The RBI’s monetary policies have managed to control rupee depreciation. The stock market is currently stable, though it is operating within a very narrow range.

The fiscal consolidation to meet the deficit target has helped contain the fiscal deficit to 3.8 percent of the GDP in Q3 of FY 2013–14. Despite the consolidation, the deficit may miss the target this fiscal year due to lower tax collections and high government expenditure in the first half of FY 2013–14. If, however, the government is determined to limit its fiscal deficit, lower government spending will likely shave a few percentage points off growth.

Longer-term outlook

The growth outlook for the economy will primarily hinge on the election outcomes. A better government with a clear mandate will likely boost business and investor confidence. However, it is difficult to predict the election results in advance, and the rising significance of regional parties will likely complicate the situation.

Once there is more political and policy certainty, growth will likely improve in the second half of FY 2014–15, but its pace will be moderate. Downward risks will remain high if global uncertainties increase. Coordinated, defined monetary and fiscal policies will likely mitigate risks as the economy continues on its path.